Despite OPEC Production Cut, Another Year Of Low Oil Prices Is Likely

OPEC Secretary General Nigerian Mohammed Barkindo (R), the Chairman of the OPEC Board of Governors Algerian Mohamed Hamel (L) and the President of the Organisation of Petroleum Exporting Countries (OPEC) Mohammed bin Saleh al-Sada (C) attend a meeting of the Organization of the Petroleum Exporting Countries, OPEC, at the OPEC headquarters in Vienna, Austria on November 30. (HERBERT NEUBAUER/AFP/Getty Images)

An OPEC production cut offers oil producers hope for higher prices in 2017. But there is a dark cloud hanging over that expectation. Global storage inventories must be substantially reduced before higher oil prices can be sustained. Some of U.S. tight oil has nowhere to go but into storage because it can neither be refined nor exported.

If all OPEC cuts take place as announced, it will be at least a year before sufficient inventory reductions allow prices to move much higher than current levels. If not, lower oil prices will last even longer.

The OPEC Production Cut and Spare Capacity

OPEC agreed to cut production in November partly because it was incapable of sustaining output at 2016 levels. Announcing a cut is a good way to cover the reality that commercial reserve limits have been reached.

Analyst narratives have created the unfounded but widely accepted belief that OPEC has a strategy, and that strategy involves a price war with U.S. tight oil producers. The cartel's inaction since 2014 more probably reflected an unwillingness to repeat the mistake of cutting output between 1980 and 1985: those cuts had little effect on world over-supply and damaged OPEC market share and revenue.

The possibility of a production freeze was suggested in February 2016 when oil prices were less than $30 per barrel. Expectation of OPEC action and improving fundamentals lifted prices to an average of $43 per barrel in 2016.

Failure to act in November probably would have sent prices into the mid-$30 range. As my colleague Allen Brooks remarked just after the cut was announced, this is more about setting an oil-price floor than about raising prices.